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Wednesday, May 2, 2007

LIQUIDITY TALK. RISK DIVERSIFICATION & MORAL HAZARD: TWO VIEWS. Gillian Tett & Chris Giles. "Traders urged to learn from subprime saga", Financial TimesCiting the recent Bank of England report on Financial Stability, Financial Times writers Gillian Tett and Chris Giles briefly discuss the issue of moral hazard in the context of the risk transfer mechanism through CDS and other innovations. "If banks think they can unload risk on to someone else", write Tett and Giles, "they may become more cavalier about making loans". Moral hazard, thus, may increase as the transfer of risk intensifies.

Not so fast, says Timothy Geithner, president and CEO of the New York Fed: "... the system as a whole may be less vulnerable to distorsions introduced by the moral hazard associated with the access that banks have to the safety net" (italics mine). In other words: as banks embrace the "originate-and-distribute" model, those moving to the "buy-and-hold" role may behave more cautiously because they do not have access to the safety net.

The two views are not necessarily incompatible. Moral hazard within banks may increase as a result of financial innovation, but it may well decrease in terms of the financial system as a whole (*).

(*) See Gillian Tett. "Hedge funds lead European leveraged lending", Financial Times: "American hedge funds and other non-bank credit investment groups now hold just over 50 per cent of all lending to risky European companies — pushingbanks into a minority role in this sector for the first time".